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The economic situation has reduced the income of many charities whilst demands on their services and expenditure are rising. Some trading charities have seen income from sales decline and loan finance has become more expensive and harder to access.
What should your charity do if it finds itself in financial difficulties?
Are we insolvent?
Broadly, a charity is insolvent if it is unable to pay its debts. Most trading charities are charitable companies limited by guarantee.
These are subject to the Insolvency Act 1986, which sets out two tests of insolvency:
- Can the charity pay its debts as they fall due? This is called the ‘cash flow’ test.
- Are the assets of the charity less than its liabilities, including its contingent and prospective liabilities? This is known as the ‘balance sheet test’.
Unincorporated charities technically cannot be insolvent, as they have no ‘legal personality’ so do not incur liabilities on their own behalf. Instead, liabilities of unincorporated charities (such as charitable trusts) are liabilities of their trustees personally.
What might happen if we are insolvent?
If a charitable company fails either test of insolvency under the Insolvency Act 1986 its creditors may present a petition to the Court requesting that it be liquidated.
If the assets of a trust are less than these liabilities, creditors can pursue the trustees personally to recover their debts.
Limited Liability?
Where a charitable company is liquidated due to insolvency, its assets will be distributed to its creditors. If these are not sufficient to discharge its debts, creditors generally will not be able to pursue the directors (or trustees) personally, as the charitable company will have limited liability.
However, the protections of limited liability are not absolute. Directors can be made to contribute from their own personal assets in certain circumstances. In particular:
- Fraudulent Trading: Where the directors knowingly carry on the company’s business with intent to defraud creditors, or for any other fraudulent purpose.
- Wrongful Trading: Essentially, where the directors recklessly or negligently allow the company to carry on trading when any reasonable person would have concluded that there was no reasonable prospect of the company being able to avoid insolvent liquidation.
How can we avoid wrongful trading?
If the directors of a charitable company know, or ought to know, that there is no reasonable prospect of avoiding liquidation, they must be able to show that they took all reasonable steps to minimise the losses of the company’s creditors.
This means that the directors’ primary duty will no longer be to act in the best interests of the charity in pursuit of its charitable objects. Instead, they will now be duty bound to act in the best interests of creditors.
Practical Steps
If the directors of a charitable company are worried that the company might be insolvent they should immediately take the following steps:
- Quickly establish an accurate picture of the company’s financial position.
- Hold regular meetings of the directors to monitor development of the company’s financial position. Discuss how to protect the interests of the company’s creditors and keep detailed minutes of any meetings to demonstrate that reasonable steps to have been taken protect creditors.
- Endeavour to stop incurring further liabilities. To protect the directors from a claim of wrongful trading, their actions must be reasonable, as viewed from the standpoint of a reasonable director.
- Take appropriate legal advice and make sure that it is confirmed in writing, to demonstrate that the directors have acted reasonably and responsibly.
- Get creative! Consider less obvious ways of improving the charity’s finances, such as by approaching possible merger partners.
Remember that you are not alone!
The ‘great recession’ has left many well managed charities facing financial difficulties. If you are one of them, you are not alone. There is much guidance available to help you steer your charity through these tough times. The Charity Commission’s information sheet CC12 “Managing Financial Difficulties and Insolvency in Charities” is a good first point of call.
Simon Steeden is a solicitor at Bates Wells & Braithwaite. www.bateswells.co.uk